The Treasury Department and IRS recently released proposed regulations intended to clarify key questions regarding investing in qualified opportunity funds (QOFs). In addition, the IRS issued a revenue ruling that provides guidance to taxpayers regarding the “original use” requirement for land.
Public comments on the proposed regulations will be accepted until Dec. 28. These proposed regulations may be changed before the agencies finalize them.
To help clarify what opportunity zones and QOFs are and how the associated tax benefits work, NAHB has answered a list of the most frequently asked questions on the subject. These questions include:
NAHB urges all taxpayers to consult with a tax and/or investment advisor prior to making any investment/financial decisions.
The following information is strictly for informational purposes and highlights only certain aspects of the proposed regulation.
What are opportunity zones and QOFs, and how do the tax benefits work?
Opportunity zones are a new investment tool created as part of the Tax Cuts and Jobs Act of 2017. It seeks to encourage economic growth in designated distressed communities (i.e. qualified opportunity zones.)
Investments into an opportunity zone flow through a qualified opportunity fund. QOFs can take the form of a corporation or partnership.
The law provides two tax incentives for investments made in an opportunity zone. First, it allows taxpayers to defer federal taxes owed on any capital gains invested in a QOF. Over time, investors may be eligible to reduce federal taxes owed on the deferred capital gains. Second, the law excludes from gross income the post-acquisition gains on investments in QOFs that are held for at least 10 years.
The deferral of federal taxes owed on the initial investment ends on December 31, 2026.
How are QOF investments treated after the opportunity zones expire in 2028?
A major source of uncertainty is the effect of the expiration of all designed opportunity zones on December 31, 2028. Under the statute, a taxpayer who holds an investment in a QOF for at least 10 years receives a stepped-up basis that excludes from gross-income the post-acquisition gains on QOF investments. Because the opportunity zones themselves only exist for 10 years, questions have been raised whether meeting the 10-year investment window requires investments to be made prior to the end of 2018.
The proposed regulations would “permit taxpayers to make the basis step-up election under section 1400Z-2(c) after a qualified opportunity zone designation expires.”
Taxpayers would be able to preserve this election until December 31, 2047. The proposed regulation would also allow a taxpayer who “makes an investment as late as the end of June 2027 to hold the investment in a QOF for the entire 10-year holding period described in section 1400-2(c), plus another 10 years.”
How does a taxpayer elect to defer capital gains invested in a QOF?
Taxpayers will make deferral elections on Form 8949, which will be attached to their federal income tax returns for the taxable years in which the gain would have been recognized if it had not been deferred.
How will a taxpayer self-certify a QOF and complete annual reporting requirements?
In general, any taxpayer that is a corporation or partnership may self-certify as a QOF. Taxpayers will use Form 8996, Qualified Opportunity Fund, for both the initial self-certification and the annual reporting of compliance with the 90-percent asset test.
What type of income is eligible for deferral?
The proposed regulations specify that ordinary gains are not eligible and that “only capital gains are eligible for deferral and potential exclusion under section 1400Z-2.” In addition, the gain to be deferred must be a gain that would be recognized not later than December 31, 2026, which is the final date under the law for the deferral of a gain. The proposed regulations would also prohibit the deferral of any gain that arises “from a sale or exchange with a related person as defined in section 1400Z-2(e)(2).”
How do the proposed regulations treat substantial improvements?
Under the statute, within 30 months of acquisition of existing property, the QOF must substantially improve the property. The additional basis of property must “exceed an amount equal to the adjusted basis of such property” when acquired.
The proposed regulations seek to further clarify how to calculate the original basis of the property by excluding the cost of the underlying land: “for purposes of this requirement, the basis attributable to land on which such a building sits is not taken into account in determining whether the building has been substantially improved.” Additional taxpayer guidance can also be found in IRS Revenue Ruling 2018-29.
What is the capital safe harbor?
In general, a QOF has six months to invest cash held in qualifying assets. However, the agencies note that concerns have been raised in circumstances when construction or rehabilitation of real estate takes longer than six months. In response, the proposed regulations would create a capital safe harbor for “QOF investments in qualified opportunity zone businesses that acquire, construct, or rehabilitate tangible business property, which includes both real property and other tangible property used in a business in an opportunity zone.” The safe harbor allows working capital to be held by the business for up to 31 months, “if there is a written plan that identifies the financial property as property held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, there is written schedule consistent with ordinary business operations of the business that the property will be used within 31-months, and the business substantially complies with the schedule.”
Taxpayers would be required to retain any written plan for their records.
What is a Qualified Opportunity Zone Business and the 90 percent test?
Under the statute, a QOF is any investment vehicle organized as a corporation or partnership. A QOF must hold at least 90 percent of its assets in qualified opportunity zone property, which includes qualified opportunity zone business property. Qualified opportunity zone business property “may also include certain equity interests in an operating subsidiary entity (either a corporation or partnership) that qualifies as a qualified opportunity zone business…”
For a trade or business to qualify as a qualified opportunity zone business, “it must (among other requirements) be one in which substantially all of the tangible property owned or leased by the taxpayer is qualified opportunity zone property.” The proposed regulations would allow the “substantially all” requirement to be met when “at least 70 percent of the tangible property owned or leased by a trade or business is qualified opportunity zone business property (as defined section 1400Z-2(d)(3)(A)(i).”
The proposed regulations note that the 70 percent requirement will give “QOFs an incentive to invest in a qualified opportunity zone business rather than owning qualified opportunity zone business property directly.” The proposed regulations highlight an example of how the 70 percent requirement might alter QOF investment behavior:
For example, consider a QOF with $10 million in assets that plans to invest 100 percent of its assets in real property. If it held the property directly, then at least $9 million (90 percent) of the property must be located within an opportunity zone to satisfy the 90 percent asset test for the QOF. If instead, it invests in a subsidiary that holds real property, then only $7 million (70 percent) of the property must be located within an opportunity zone. In addition, if the QOF only invested $9 million into the subsidiary, which then held 70 percent of its property within an opportunity zone, the investors in the QOF could receive the statutory tax benefits while investing only $6.3 million (63 percent) of its assets within a qualified opportunity zone.
The agencies indicate within the proposed regulation that they are “considering setting this ‘substantially all’ threshold at 90 percent” in order to “reduce the incentive the QOF has to invest in a qualified opportunity zone business rather than directly owning qualified opportunity zone business property.”
Can pre-existing entities qualify as a QOF?
The proposed regulations would not prohibit “using a pre-existing entity as a QOF or as a subsidiary entity operating as a qualified opportunity business, provided that the pre-existing entity satisfies the requirements under section 1400Z-2(d).”
How can I submit comments to the Treasury and IRS?
Taxpayers may submit comments electronically via the Federal Rulemaking Portal at www.regulations.gov, referencing IRS REG-115420-18. All comments are due by Dec. 28, 2018.
Will there be additional regulations?
Treasury and IRS can always issue additional regulations to clarify issues that arise over time. At a minimum, the agencies intend to publish additional proposed regulations to address penalties and conduct that may lead to potential decertification of a QOF.
NAHB is providing this information for general information only. This information does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind nor should it be construed as such. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action on this information, you should consult a qualified professional adviser to whom you have provided all of the facts applicable to your particular situation or question. None of this tax information is intended to be used nor can it be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.